Shops are slashing prices and inflation keeps tumbling - so is deflation the new threat to Britain's economy?

For much of the past two years, it
has been inflation causing the biggest stir. When it hit a peak of 5.2
per cent last year, consumers were squeezed hard.

Bargain hunter: A shopper in London's Oxford Street

With prices far higher
than the year before, shoppers bought less - and that has had repercussions
for the economy.

The fear has been that with Britain's
colossal debts, the authorities would collude to create inflation,
which would steadily erode away the borrowing problem.

With more than £1trillion of government debt and nearly £1.5trillion owed by consumers, Britain is ranked just behind Japan on the world league table of debtors.

But inflation is no longer doing the heavy-lifting on our debt problem.

The British Retail Consortium today said overall shop price inflation slowed to 1.1 per cent in June from 1.5 per cent in May, its lowest level in
two-and-a-half years.

The price of non-food
goods, like clothing, electrical goods and DIY hardware, are now falling. The annual rate of deflation was 0.3 per cent, worse than the 0.1 per cent figure in May.

The consumer prices index is down to 2.8 per cent, in May, and
inflation seems less of danger. It remains above the 2 per cent target,
but CPI could be as low as 1 per cent by the end of the year.

Capital Economics, a forecaster with a strong track record, today warned that the rate of inflation was set to tumble.

In its UK Economics Chart Book for July, published today, the company's economists wrote: 'The near-term inflation outlook has improved significantly in recent weeks. Inflation has fallen below3 per cent for the first time since the end of 2009. It will come under further downward pressure from the recent drop in oil and petrol prices. And we still expect core inflation of to fall sharply.'

Core inflation strips out more volatile elements, such as food and energy prices.

Capital Economics added: 'Although the core rate nudged up in May, this reflected base effects – the seasonally adjusted monthly change was weak. Inflation could now fall as low as 0.5% or so at the start of next year.'

The inflation forecast from Capital Economics shows CPI falling as low as 0.5% early next year

At the start of the financial crisis,
deflation was regarded as the bigger danger. Once it takes hold, it can
be difficult to reverse as consumers put off buying goods on the
hope of buying them cheaper further down the line, especially economy-boosting, big-ticket goods like cars.

More menacingly, it also means those debts - and more than £1trillion in mortgages, effectively grows relative to wages and other
prices.

Japan's experience is
a parable for central bankers. The country had a property boom that
peaked in 1989 and turned to banking collapse, followed by two decades
of on-off falling share prices and property values.

The Bank of England and the Federal
Reserve, in particular, have pulled out the stops to avoid that
scenario. The Bank has pumped £325billion of electronically-created
money into the economy in recent years, which has helped to create
inflation. Tomorrow, the monetary policy committee (MPC) is expected to announce another round of
this quantitative easing (QE).

The vote against QE was only 5-4 at the last meeting of the MPC. The Governor, Sir Mervyn King, wanted more stimulus.

Howard Archer, an economist at IHS Global Insight, said: 'We suspect that latest developments are likely to prod at least one more MPC member into favouring more QE in July, and expect a £50billion extension to be announced, taking the stock up to £375billion.'

The warning in our 2009 prediction for the next decade [what to expect in 2020], was that the new QE tool would be back time and again.

A spiral of falling prices, as we've long warned on our interest rates prediction page, has remained the underlying danger throughout the crisis and will stalk the economy for years to come. It is only the money printing efforts that have warded it off. So expect more money printing, rock bottom rates and an ongoing battle with the deflationary demon.